Thursday, January 21, 2016

Why Companies Are Choosing to B Good: A Closer Look at Delaware Public Benefit Corporations

As of August 1, 2013, the Delaware Legislature added Subchapter XV to its Delaware General Corporation Law (“DGCL”) providing for the formation of a Public Benefit Corporation (“PBC”). As of now, 31 states (including the District of Columbia) have enacted similar statutes, with Maryland and Vermont leading the way by becoming the first states to do so in 2010.  You can check the status of benefit corporations in each state here. This blog, however, will focus only on Delaware PBCs. Delaware is home to over 1,000,000 corporations.  Approving a PBC entity structure in Delaware is an endorsement of corporate culture that aims to conduct business in a responsible and sustainable manner.

Similar to a regular corporation, a PBC is a for-profit corporation that, in addition to maximizing shareholder value, is committed to pursing a purpose that would create a public benefit. There are however key differences that set these two types of entities apart. This blog will discuss differences between the two entity structures and why this new corporate structure is so enticing to socially conscious entrepreneurs.

Formation and Purpose

In its certificate of incorporation, a PBC must identity itself as a public benefit corporation (that means that it is going to have “P.B.C.” or “PBC” at the end of the name rather than an "Inc.") and must list at least one public benefit that it intends to pursue.

Section 362 (b) of DGCL defines a public benefit as a “positive effect (or reduction of negative effects) on one or more categories of persons, entities, communities or interests (other than stockholders in their capacities as stockholders) including, but not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature.”

Responsibility and Reporting Requirements

Unlike in a traditional corporation, directors in a PBC must provide a biennial (once every two years) report to the shareholders describing the corporation’s promotion of the public benefit identified in its certificate of incorporation. The report has to include the objectives established by the board to promote the public benefit; the standards adopted by the board to measure the corporation's progress in promoting such public benefit; objective factual information based on those standards regarding the corporation's success in meeting its objectives; and finally an assessment of the corporation's success in meeting its objectives.

This requires taking additional corporate governance steps, including the development of clearly defined objectives and standards that can be measured and quantified in order to assess the corporation's success in meeting its public benefit goals.  

Fiduciary Duties

Directors owe fiduciary duties of care and loyalty to both the company and the shareholders. The duty of care requires directors to act in the same manner as a reasonably prudent person in their position would. The business judgment rule offers directors some protection in this category from any losses incurred under their watch as long as the decisions were made in good faith and with reasonable skill and prudence. The duty of loyalty is an affirmative duty to protect the interests of the corporation, and also an obligation to refrain from conduct which would injure the corporation and its shareholders such as self-dealing. 

A PBC's board duties are pretty much the same.  However, when making decisions, the directors are required to balance the "pecuniary interests of the stockholders, the best interests of those materially affected by the corporation's conduct, and the specific public benefit or public benefits identified in its certificate of incorporation." DGCL 365(a).

In a change of control situation, the business judgment rule standard of review applied to a regular corporation's board of directors is changed to that of enhanced scrutiny standard (remember the Unocal and Revlon decisions?) (Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. 506 A.2d 173 (Del. 1986)). At the time of a company sale or a takeover, directors are required to maximize the shareholders' value by seeking the highest price available. However, in a Delaware PBC, the board's duty to consider other constituencies and society as a whole does not go away in the context of a merger or a takeover. A Delaware PBC board cannot simply sell to the highest bidder. It needs to consider and which acquirer would be most suitable to continue furthering the corporation's public benefit purpose.

Benefit Corporation vs. B Corp Certification

Often used interchangeably, a PBC and a B corp should not be confused with one another. A PBC is a legal entity form (like an LLC or a corporation or a partnership), while a B Corp is a certification awarded by B Lab, a non-profit organization that serves the global movement of people using business as a force for good. In order to obtain the certification, the company must first become a benefit corporation in its home state. There is a strict process to become certified. Additionally, B Lab charges annual fees which are assessed on a sliding scale, starting at $500 for companies with revenues of less than $1 million to $50,000 for companies with revenues over $1 billion.  Etsy, Patagonia, Warby Parker, Plum Organics are all examples of companies that received certification as B corp companies.

Thinking of Converting?

A traditional corporation can easily be concerted to a PBC by filing an amendment to its certificate of incorporation with the DE Department of State. The amendment would require an approval of 90% of the outstanding shares of each class of stock (whether voting or nonvoting) of the corporation.  A merger or a consolidation with a domestic or foreign PBC also requires the same 90% vote.

Perhaps one of the largest recent converts from a traditional C corporation to a PBC (2015) is Kickstarter, PBC (formerly, Kickstarter, Inc.) Kickstarter, a crowdfunding platform, proudly lists their conversion on their website along with their mission statement “to help bring creative projects to life.”  Since its conversion, Kickstarter has received a lot of publicity regarding their new status and has been branded as one of the many companies that want to be apart of movement demonstrating they are not all about maximizing profits. Articles discussing their recent conversion to a benefit corporation can be found here and here.

Going Back

A two-thirds vote of the outstanding shares of each class of the PBC, whether voting or non-voting, is required to terminate the PBC status.  This makes it difficult for just one group within the corporation to decide to revert to a regular corporation status, unless supermajority of the corporation's shareholders also agree.

Is There Really a Downside?

This new entity type allows companies to legally use their resources to advance a public purpose that they believe in, while working towards increasing company revenue. How can there be a downside? Some say that small companies and start-ups choosing to register as benefit corporations may have harder time securing investors because benefit corporations may not always have the same returns as regular corporations.  However, this is changing. According to B Lab, many lead VC funds have invested into benefit corporations.  

Here is the list: Abundance Partners, Andreessen Horowitz, Baseline Ventures, Benchmark, Betaworks, Brand Foundry, Bullet Time Ventures, Capital, Freshtracks Capital, Claremont Creek Ventures, Collaborative Fund, CommonAngels Ventures, DBL Investors, Emerson Collective, First Round Capital, Forerunner Ventures, Formation|8, Founders Fund, Foundry Group, Generation Equity Investors, Good Capital, Greycroft Partners, Hallett Capital, Harrison Metal, Impact America Fund, Kapor Capital, Kortschak Investments, Learn Capital,Lighter Capital, Matrix Partners, New Enterprise Associates, New School Ventures, Omidyar Network, Pacific Community Ventures, Peterson Ventures, Prelude Ventures, Reach: New Schools Capital,Red Swan Ventures, Renewal Funds, Serious Change, SherpaVentures, Tekton Ventures,The Westly Group, Thrive Capital and Union Square Ventures.

Another disadvantage that a PBC must endure is their reporting requirement to the shareholders regarding whether or not the company is successfully working towards and fulfilling their public purpose. The good news here is that in Delaware, the reporting requirement is not as onerous as in several other states. Delaware PBCs are not required to (i) appoint a benefit director or officer; (ii) disclose the benefit report to the secretary of state; (iii) use a third party standard or assessment in connection with the report; (iv) prepare the report annually; or (v) consider the impact of every single corporate decision on a variety of stakeholders (shareholders, employees, customers, etc.).

So, being a benefit corporation may not be such a disadvantage after all.

Delaware PBC Act is flexible, and combined with the authority and weight of DGCL in general, may make a big shift in the US corporate culture towards a greater use of benefit corporations to conduct business. It just might pay to B good.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.

Wednesday, January 20, 2016

Potential Risks Companies Face When Engaging Unregistered Finders

When raising capital, some companies engage “finders” to make introductions to their substantial networks of potential investors. This sounds great so long as that finder also happens to be a broker registered with the Securities and Exchange Commission (the “SEC”). However, in practice not all finders are registered. Companies face some serious risks when engaging an unregistered finder. This blog’s purpose is to highlight the distinction between the two roles and explain the precise risks of using unregistered brokers.

Is the individual a broker?

The Securities Exchange Act of 1934 (the “Act”) defines a broker as any person engaged in the business of “effecting transactions in securities” for the account of others. “Effecting transactions” is broadly construed as soliciting, structuring, negotiating and/or executing securities transactions, identifying potential purchasers, handling money for someone else, or receiving transaction-based compensation.

Some examples of activity that may require registration as a broker-dealer include, but are not limited to:
  • Effecting securities transactions for the account of others for a fee or purchasing or selling securities at a regular place of business for the entity’s own account;
  • Operation of an electronic or other platform to trade securities;
  • Acting as a placement agent for the private placement of securities;
  • Acting as a finder of investors for issuers or the sale of securities;
  • Finding investors (even if in a “consultant” capacity) or customers for, making referrals to, or splitting commissions with registered broker-dealers;
  • Participating in a selling group or underwriting of securities, finding investment banking clients for registered broker-dealers;
  • Providing support services (such as clearing and settlement) to registered broker-dealers;
  • Finding investors for venture capital financings, including private placements;
  • Finding buyers and sellers of businesses where securities are involved; or
  • Advertising as a market maker or providing continuous quotes in securities.
The single most important factor in determining whether the person is acting in a broker capacity is the receipt of compensation tied to the success of the transaction. The SEC has made it clear that “a person’s receipt of transaction-based compensation in connection with these activities is a hallmark of broker-dealer activity.” We know this from the SEC’s no-action letters. A no-action letter is the SEC Staff’s response to a company’s inquiry. A no-action letter says that the SEC will not take an enforcement action against the company if it agrees with its interpretation of certain laws as they relate to that particular company’s actions. No-action letters are public, and other companies can refer to them as guidance. In one such relatively recent (2006) no-action letter, the SEC disagreed with the company’s position that the activity did not warrant broker registration. In that case, John W. Loofbourrow Associates, Inc. (“Loofbourrow”), a registered broker-dealer wanted to pay Eagle One Mortgage Solutions, Inc., (“Eagle”), an unregistered entity, a finder or referral fee for introducing potential investment banking clients to Loofbourrow. Eagle would (1) not be involved in structuring or placing the securities; (2) be limited to introducing the parties; (3) not be involved in any negotiations or make any recommendations; (4) not offer or sell any securities or solicit any offers to buy securities; and (5) not handle funds or securities. The fee paid to Eagle by Loofbourrow would be a commission-like arrangement tied to the ultimate size of the amount of securities offered, if and when Loofbourrow successfully placed the securities. (John W. Loofbourrow Associates, Inc. No-Action Letter (June 2006)). This no-action letter shows that the receipt of transaction-based compensation in connection with a securities transaction ALONE is enough to warrant registration.

Similarly, in a June 2007 no-action letter to Hallmark Capital Corp. (“HallCap”), the SEC stated that it appeared that HallCap would be required to register with the SEC as a broker-dealer. HallCap assisted small businesses with revenues under $25 million with their debt and equity capital needs. HallCap would prepare a confidential information summary describing the business, identifying broker-dealer firms that might be interested in working with the company, and arranging meetings leading to an engagement of the broker-dealer by the client company to raise capital. Once the broker-dealer was engaged, it had control of and oversight over all significant aspects of any securities transaction, including investor solicitation and execution of the transaction. HallCap was compensated with a modest upfront retainer and a fee based on the outcome of the transaction. (Hallmark Capital Corporation No-Action Letter (June 11, 2007).

Finder's Exception

There is a very very narrow exception from registration for individuals who merely act in the capacity of a “finder.” In deciding whether the person acted as a broker or a finder, the SEC typically looks at the totality of circumstances. The following questions typically get analyzed:
  • Does the individual receive transaction-based compensation, such as commissions or referral fees?
  • Does the individual engage in solicitation of potential investors?
  • Does the individual participate in the various aspects of a securities transaction, including solicitation, structuring advice, and negotiation? 
  • Is he or she an active rather than passive finder of investors? 
  • Is the individual otherwise engaged in the business of effecting securities transactions or was previously disciplined for such activity? and 
  • Does the individual handle securities or funds in connection with the transaction. 
If a company feels that, after reading all this, it still absolutely must engage an unregistered finder in connection with raising capital, then the following guidance might help avoid potential liability:

1. The finder should only be involved with making introductions to suitable, accredited investors.

2. The individual should not solicit or pre-screen any investors on behalf of the company.

3. The finder should also be sure to avoid any substantive discussions with any potential investors of your company.

4. The finder should not participate in any negotiations, discuss the value of the investment, handle any funds or securities involved with completing a transaction, or hold themselves out as providing any securities-related services.

5. The finder should also not assist an issuer or potential investor with the completion of any transaction.

6. The individual should avoid transaction-based compensation. Non-contingent fixed fee compensation may be acceptable but it should not be based on the success of the deal. The fee should be paid regardless of how the deal turns out.

7. The finder may perform ministerial function of facilitating the exchange of documents or information.

8. As an independent contractor, the finder should not have authority to speak on behalf of the company in any way.

Bad Things That Can Happen to the Company

There are many risks the company may face when engaging an unregistered finder.

1.  Rescission. Under Section 29(b) of the Act, contracts entered into in violation of the Act may be rendered void. Additionally, the company may also be violating state securities laws, and investors may again get rescission rights (i.e., they can demand their money back).

2.  Loss of Exemption from Registrations. The use of unregistered broker-dealer may cause the company to lose its exemption from the registration requirements of the Securities Act of 1933, and from applicable state laws. The SEC may issue a cease-and-desist order, seek civil money penalties, and even refer the matter to the attorney general for prosecution. In accordance with the bad actor disqualification provisions of Rule 506 of Regulation D adopted by the SEC in July 2013, an offering by an issuer would be disqualified if there was an SEC disciplinary order or a cease-and-desist order. This would be very damaging to the company’s reputation and ability to raise capital in the future.

3.  Risks relating to disclosure obligations. There is risk that a finder’s failure to disclose the fact that it is not registered as a broker-dealer could itself be characterized in regulatory enforcement proceedings or private litigation as the issuer's misleading omission that amounts to fraud on the issuer under Section 10b-5 of the Securities Act. This could prevent future investors from wanting to invest in the company and may prevent any legal counsel working on behalf of the company from issuing legal opinions in connection with a subsequent finding.

4.  Aiding and Abetting Liability. The issuer may be subject to civil and criminal penalties, including pursuant to Section 20(e) of the Act on the theory that the company aided and abetted an unregistered broker-dealer.

5.  Private Actions. There could be a private action brought by investors for damages suffered.

The SEC appears to be strictly enforcing regulations requiring broker-dealer registration. Although tempting, a company should strongly consider all potential risks prior to engaging a finder and not just evaluate an individual based on the size of their Rolodex.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.


Wednesday, September 30, 2015

Placement Agents: Part II: When Should You Use a Placement Agent, and How to Pick the Right One?

At this point, having discussed the services a placement agent can provide, the kinds of compensation used, and other important terms to keep an eye on when negotiating for the services of a placement agent, there is still the threshold matter of determining whether using placement agents makes sense (and when it doesn’t) in the first place. In addition, how to decide which specific placement agent to use?

The first thing to keep in mind is that placement agents are much more common in later-stage financing rounds. Placement agents are almost never used in seed rounds or early-stage financing. One reason for this is that the universe of potential early-round investors (e.g., VC firms and funds) is much smaller and, for lack of a better word, self-contained. In addition, pertinent information, such as what sorts of companies particular VCs invest in and at what dollar amounts, is often publicly available to a much greater extent than for later-stage investors. On a practical level, companies in the early fundraising stages may also be less willing or able to pay the significant commissions demanded by placement agents for their services. This does not mean, of course, that it is never helpful or necessary to use a placement agent in an early-stage fundraising round, but they are used much more commonly—and are in general much more helpful—in later-stage rounds by companies with some kind of established track record.

That being said, if an issuer feels that it can be successful in raising capital without employing the services of a placement agent (for example, perhaps it has only a few major investors who are willing to fully finance a later round), then there is nothing which requires that a placement agent be used. Any money not paid out to placement agents as commissions in a private placement is money the company retains for its own use.

Sometimes, however, using a placement agent is necessary or helpful. For example, if the company is contemplating multiple rounds of private placements over an extended period of time, hiring a placement agent that can introduce the company to a significant number of potential investors (and who may be willing to invest in multiple financing rounds) could be very beneficial. Obviously, if the company has had difficulty raising capital in the past or is facing low interest in the present, hiring a placement agent may be helpful. If conditions in the broader economy are difficult, the services of a placement agent may also be necessary. In the end, the decision whether to hire a placement agent will depend on the circumstances.

If you are considering using a placement agent, you will want to do your homework, as with any potential partner. From a legal standpoint, the most crucial requirement is that you only use a registered BD as a placement agent. This is because any BD acting as a placement agent will be deemed to be “participating” in the offering, and according to both SEC and FINRA regulations, only registered BDs are allowed to so participate. A company should be particularly wary of so-called “finders”, which are not registered BDs. A “finder” may offer to introduce companies to investors, but nothing else—they do no assist with the PPM, do not talk to investors on behalf of the company, etc. It is very important to keep in mind, however, that both the SEC and FINRA define “participation” very, very broadly, and if they find that non-registered persons have participated in the offering, the penalties can be severe, including, for example, “rescission” (i.e. returning any money accepted back to investors).

After making sure that the placement agent you use is a duly-registered BD, there are additional considerations to keep in mind. Some placement agents, for example, may specialize in certain kinds of companies (e.g. software companies or pharmaceutical companies), certain kinds of offerings or transactions (e.g. debt or equity offerings), certain kinds of investors, or certain regions (whether within the United States or with overseas investors). You should ask potential placement agents to put you in contact with other companies who have used their services in the past (though note that the particular terms, such as compensation, are likely covered by confidentiality). Information, as always, is power, and the more information your company can obtain about your potential placement agent partner, the more confident you can be that the placement agent you are partnering with will help you achieve your company’s goals.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.